Tax Benefits of Incorporating in Canada

In this article, Toronto business lawyer, Antonio DiMinno of DiMinno Rizzi Lawyers, answers the question: “What are the tax advantages of incorporating my business?”  

Did you know that incorporating your business in Canada could unlock a treasure trove of tax benefits? It’s a strategic move that savvy entrepreneurs use to not only protect their assets but also to significantly reduce their tax burden. With my extensive experience in guiding business owners through the incorporation process, I’ve seen the profound impact these tax advantages can have. From lower corporate tax rates to income-splitting opportunities, the fiscal perks of incorporation are many. As we delve into the tax benefits of incorporating in Canada, we’ll uncover how incorporating can lead to a more prosperous and secure financial future for your business.  

What does It Mean to Incorporate in Canada?

Incorporating a business in Canada is a significant step that can open doors to numerous tax advantages. However, the process and implications of incorporation are often misunderstood, leading to missed opportunities or unexpected challenges. Drawing from my years of experience working with Canadian entrepreneurs and businesses, let’s examine the basics of business structure and incorporation before getting into the tax advantages.  

Types of Business Structure

As an entrepreneur, understanding the structure of your business is crucial. In my experience, most businesses have one of the following structures: sole proprietor, partnership, and corporation.  

If you’re running a business solo in Canada, you’re known as a sole proprietor. This means you and your business are essentially one and the same in the eyes of the Canada Revenue Agency. The money your business makes is taxed as your personal income, which varies based on how much you earn and where you live in Canada. If your business isn’t doing well and you’re facing losses, you can use these losses to lower your personal taxable income. This might not only reduce your tax bill but could also place you in a lower tax bracket, offering some financial relief. 

Where there is more than one business owner, you may opt for a partnership. Essentially , you and at least one other person own the business together, sharing both the profits and the losses. Tax-wise, it’s similar to being a sole proprietor since the business itself doesn’t file taxes. Instead, you and your partners report your individual shares of income on your personal tax returns. 

It’s important to note that both sole proprietors and partners are personally on the hook for any business debts. If your business can’t pay its bills, your personal assets, like your savings or even your home, could be at risk. 

Now, if you decide to incorporate, that’s a game-changer. Your business becomes its own legal entity, separate from you. This shields your personal assets from business debts to a significant extent. Plus, incorporation can unlock tax benefits that sole proprietors and partners don’t have access to. 

Remember, each business structure has its own implications for protection and taxes, so choose the one that aligns with your financial goals and risk tolerance. 

Let’s dive in more detail on incorporation.  

What is Incorporation?

Incorporation is the process of legally establishing a business as a separate entity from its owners. This means that the corporation itself, not the individuals who own or run it, holds the assets, liabilities, and conducts business operations. In Canada, a corporation is treated as a ‘person’ under the law, allowing it to enter contracts, own property, and even sue or be sued. 

To learn more about incorporation is and how it’s different from other legal entities, check out our article: Should I Incorporate My Business in Canada

Federal vs. Provincial Incorporation

One of the first decisions you’ll face when incorporating in Canada is whether to incorporate federally or provincially. Each option has its advantages and considerations: 

• Federal Incorporation: This allows your business to operate across all Canadian provinces and territories under the same corporate name. It provides broader name protection and is ideal for businesses with a national or international focus. However, if you choose federal incorporation, you’ll still need to register your business in any province or territory where you conduct operations.  These corporations are covered by the Canadian Business Corporations Act.

• Provincial Incorporation: If you incorporate at the provincial level, your business will be registered to operate within that specific province. This might be suitable for businesses with a more localized focus. Remember, if you later decide to expand your operations to another province, you’ll need to register there as well.  These corporations are covered by the Ontario Business Corporations Act.

In my experience, it’s essential to consider your long-term business goals when making this decision. Learn more about Federal vs Provincial Incorporation here.  

Regardless of the choice you make, you will still receive the full range of tax advantages that come with incorporating a business. 

Key Benefits of Incorporation

While there are many tax advantages to incorporation which we will explore, some general advantages include: 

• Limited Liability: One of the primary reasons business owners incorporate is to limit the personal liability of the owners. In a corporation, the business’s debts and obligations are separate from the personal assets of its owners, offering legal protection and asset protection. 

• Continuous Existence: A corporation’s business structure ensures continuous existence even if the owners change or pass away. This stability can be crucial for long-term business planning and succession, safeguarding the business income and operations. 

• Potential for Lower Corporate Tax Rate: As we’ll see, corporations can benefit from a lower corporate tax rate compared to the tax liability of a Sole Proprietorship, especially if they qualify for small business tax deductions. This can result in significant tax savings and allow for more strategic tax planning. 

• Tax Breaks and Business Deductions: As we’ll see, incorporation can provide access to various tax breaks and allow for a wider range of business deductions, reducing overall tax obligations and enhancing tax benefits. This includes deductions on business expenses, which can improve the financial health of the business entity. 

This is a very basic review of some of the benefits of incorporation. For a complete review of the benefits of incorporation, check out our article “What are the advantages of incorporating my business?”

Incorporation is a significant decision that can shape the trajectory of your business structure. Throughout my career, I’ve seen firsthand the power of incorporation for Canadian business owners.  

However, it’s not a one-size-fits-all solution. It requires careful tax planning and consideration of tax implications to ensure it aligns with your business strategy and business growth objectives. 

Tax Benefits of Incorporating a Business in Canada

In this section, we’ll delve deeper into the specific tax benefits of incorporating in Canada, providing you with the knowledge and insights to make informed decisions for your business’s future. 

Lower Corporate Tax Rates Compared to Personal Rates

Incorporated small businesses in Canada can take advantage of a lower federal corporate tax rate of 9% on the first $500,000 of active business income, thanks to the small business deduction. When combined with provincial taxes, the total tax rate can range from 9% to 12.2%, depending on where the business is located. This is quite favorable compared to personal income tax rates, which for some individuals can be more than 50%. 

To benefit from the lower corporate tax rates, profits must stay within the company. If business owners need funds for personal use, they must pay themselves through salaries or dividends, which are taxed at personal income rates. For instance, if a company earns $200,000 and the owner requires $100,000 for personal expenses, they could leave $100,000 in the company. This amount would be taxed at the corporate rate, allowing the owner to defer personal taxes on these funds until they are taken out of the company.  

You should first consider your income before incorporating. See our article At What Income Should I Incorporate? to learn more.

Tax Deferral

When you run a company, you might find it makes more money than you need for your own expenses. If you incorporate, you get a tax perk: you only pay personal taxes on the money you take out for yourself, like a salary or dividends. The rest of your company’s profit can stay in the business. You won’t pay personal taxes on it until you decide to use it. This could be later when you might want to grow your business, save for retirement, or plan other financial moves that could also lower your taxes. 

Keeping your profits in the company means you can plan better for the future. You’ll have more control over your taxes, letting you save more now and only pay those taxes when you’re ready. Incorporating sets you up to increase your savings and invest in your company’s growth. 

To learn more about your potential tax savings, check out our article, How Much Tax Do I Pay When Incorporated?

Example

To understand the tax deferral benefits of incorporation, let’s look at a real-world scenario from one of our clients. 

Meet Alex, an electrician with his own business in Hamilton, Ontario. Annually, Alex’s business brings in $200,000. His business costs, which include equipment purchases and vehicle maintenance, come to $25,000. Alex is on his own and depends on his business for his livelihood. His personal expenses for living, which cover his apartment, groceries, and local travel, total around $40,000 each year. 

By incorporating, Alex finds that he can keep an extra $14,291 in his business account ($92,125 – $77,834) for future use or for times when he might be earning less. This boost in available cash overshadows the one-time cost of incorporating. Plus, this isn’t just a one-off; Alex stands to gain this financial advantage every year going forward. 

Learn more about How Much Does it Cost to Incorporate?

Tax Deferral For Business Growth  

Incorporating your business can lead to faster growth because of the lower corporate tax rate. You pay personal taxes only on the salary you take from your company, which means you can leave more money in the business to use later. This way, you keep more of what you earn to cover costs and help your business grow. 

Let’s say you’re on your own, running a business. For every $100 you make, you could end up with less than $47 to reinvest after taxes and other deductions. But if your business is incorporated, you could have about $88 from every $100 to put back into your business. 

With this extra money, you could hire someone to handle time-consuming tasks, freeing you up to focus on growing your client list. Or, you might invest in new marketing tactics or training to improve your skills. Maybe you’ll add another salesperson to your team, earning more through their sales. 

The more you reinvest, the more your business can make, and this extra profit is also taxed at a lower rate. This cycle can turn your business into a powerful engine for making money. Incorporating can be a smart move to help you save on taxes and reinvest in your success. 

Income Splitting

As an entrepreneur or advisor to business owners, I’ve seen firsthand how income splitting can be a powerful tool to optimize tax efficiency. When a business is incorporated, it opens up the possibility of paying dividends to family members who are shareholders. This strategy can be particularly effective if those family members are in lower tax brackets. 

Paying Dividends to Family Members

When we pay dividends to family members, we’re essentially distributing the company’s profits. If you have adult children or a spouse with lower income, by making them shareholders, you can allocate dividends to them. This means the dividends are taxed at their lower marginal tax rate, rather than at your higher rate. It’s crucial, however, to be aware of the Tax on Split Income (TOSI) rules which can apply to dividends received by family members under certain conditions, potentially taxing them at the highest marginal rate. To navigate this, you should ensure that any of your family members receiving dividends are actively engaged in the business or meet other exceptions to the TOSI rules.  

For entrepreneurs looking to implement these strategies, it’s important that you take these steps: 

1. Assess Your Family’s Involvement: Determine if family members are involved in the business and to what extent. This will guide you on whether to pay them dividends or a salary. 

2. Consult with a Tax Professional: Before proceeding, it’s wise to consult with a tax advisor and business lawyer. They can provide personalized advice based on your business and family situation, ensuring compliance with the latest tax laws and regulations. 

3. Document Everything: Maintain clear records of all payments and the roles of family members in the business. This documentation will be invaluable for tax purposes and in the event of a CRA audit. 

4. Review Annually: Tax laws and personal circumstances change. An annual review of your income splitting strategy will ensure it remains effective and compliant. 

By incorporating these practices, we can not only foster a family-oriented business environment but also leverage tax planning opportunities to retain more earnings within the family unit. It’s a win-win situation when done correctly and responsibly. 

Flexible Renumeration Structures

When I advise clients who are sole proprietors, a critical point we discuss is the Canada Pension Plan (CPP) contributions. As a sole proprietor, you’re required to pay into CPP, which is essentially a long-term savings plan that provides funds upon retirement. However, these contributions represent cash that is tied up until that future date. 

Flexibility with a Corporation

The game changes when you transition to a corporation. As the owner, you’re presented with a choice: take a salary and continue to contribute to CPP, or opt for dividends, which are not subject to CPP contributions. This decision is pivotal because it affects your immediate cash flow and investment potential. 

Salary vs. Dividends

Choosing to pay yourself a salary means you’re an employee of your corporation, and CPP contributions are mandatory. It’s a forced savings plan for your retirement, but it also reduces the working capital you have available now. 

On the flip side, if you pay yourself dividends, you’re not required to make CPP contributions. This can significantly increase your current cash flow, freeing up funds to reinvest in your business or other ventures, potentially yielding a higher return. 

Strategic Considerations

For those considering this option, it’s important to weigh the benefits of immediate cash flow against the security of contributing to CPP. Here are some steps to take: 

1. Evaluate Your Retirement Plan: Consider your retirement goals and whether you have alternative plans beyond CPP. 

2. Assess Your Business Needs: Determine if your business could benefit from the additional cash flow that would otherwise go to CPP. 

3. Consult with a Financial Advisor: Discuss with a professional to understand the long-term implications of not contributing to CPP. 

4. Make an Informed Decision: Choose the option that aligns with your financial strategy, both for the present and the future. 

By understanding the flexibility a corporation provides, you can make informed decisions that support your business’s growth and your financial well-being. 

Save Tax When You Sell Your Business: The Capital Gains Exemption

In my experience working with business owners, one of the most significant tax planning tools available in Canada is the Lifetime Capital Gains Exemption (LCGE). This exemption can be a game-changer when it comes to selling your business. 

When you create a successful business, selling it can come with a big tax advantage. Companies can use a special tax break called a lifetime capital gains exemption. This means when you sell your company’s shares, you can keep more of the profit—up to $971,190—without paying tax on it. This kind of tax break isn’t available if your business isn’t incorporated. Plus, this tax benefit can apply to your estate, reducing taxes on the company’s shares when they’re passed on after your death. 

Life Time Capital Gains Exemption When Selling Your Business

Here is an example from our own experience that illustrates the massive savings from the LCGE: 

One of our clients, Jonathan, owned an innovative Air BNB arbitrage company that had cleverly capitalized on the sharing economy by leasing properties and then re-renting them on Air BNB for a profit. Over the years, their savvy business model flourished, and when it came time to sell, they were looking at a substantial capital gain.  

Over 11 years, Jonathan took the business from being worth only $100,000 to being worth 2.2 million dollars. He sold the business for 2.3 million to a private equity firm, making a profit of 2.2 million. 

Without the LCGE, Jonathan would have paid capital gains tax on half of his profit. This means he would be taxed on $1.1 million, and with a personal income tax rate of 50%, he’d owe the government $550,000. 

However, we helped Jonathan take advantage of the LCGE. With this exemption, $971,190 of Jonathan’s 2.2 million profit was shielded from tax. This reduced his taxable gain to $1,228,810, meaning he would be taxed only on $614,405. At the same personal income tax rate of 50%, his tax bill was reduced to $307,202.50, instead of $550,000. 

By applying the Capital Gains Exemption, we were able to save Jonathan $242,797.50 in taxes, money that he could reinvest in his next venture or enjoy in his well-earned retirement. 

Corporate-Exclusive Tax Deductions

In my professional tenure, I’ve witnessed firsthand the transformative impact that corporate-exclusive tax deductions can have on a company’s financial health. These deductions are a cornerstone of strategic tax planning, offering corporations avenues to reduce taxable income that are not available to sole proprietorships or partnerships. 

The Advantage of Capital Cost Allowance

One of the most significant deductions exclusive to corporations is the Capital Cost Allowance (CCA). This is the means by which Canadian businesses can annually claim depreciation on capital assets. What makes the CCA particularly advantageous for corporations is the ability to strategize the timing of these deductions to offset higher income years, thereby managing the company’s tax burden more effectively. 

Deducting Carrying Charges and Interest Expenses

Corporations have the unique ability to deduct carrying charges and interest expenses incurred to earn business income. This includes interest on loans taken out for business purposes and fees paid for certain financial services. In my practice, advising clients on how to properly leverage this deduction has often led to significant tax savings and improved cash flow management. 

Maximizing Loss Carryovers

Another powerful tool in the corporate tax kit is the ability to carry losses forward or back to offset taxable income. Corporations can carry non-capital losses back three years and forward up to twenty years, providing considerable flexibility in tax planning. This can be particularly beneficial for startups that may operate at a loss in their initial years but expect profitability down the line. 

Exclusive Tax Credits and Incentives for Canadian Corporations

Throughout my career as a business lawyer, I’ve had the opportunity to assist numerous corporations in navigating the intricate world of tax credits and incentives that Canada offers exclusively to them. These fiscal benefits are crafted to bolster the corporate sector’s contribution to the economy and can be a game-changer for businesses that know how to utilize them effectively. 

Investment Tax Credits

Investment Tax Credits (ITCs) are a boon for corporations, providing direct deductions from taxes owed. The Scientific Research and Experimental Development (SR&ED) program is a prime example, offering credits for R&D activities. However, beyond SR&ED, corporations can also benefit from ITCs for certain capital investments, such as those in energy conservation and clean energy generation, which are not typically available to non-corporate entities. 

Provincial Nominee Programs

Each Canadian province offers its own suite of incentives to attract and retain corporate investment. For instance, provinces like British Columbia and Quebec provide tax credits to corporations for activities ranging from digital media production to the development of e-business. These incentives are often substantial and are tailored to support corporations in becoming more competitive within specific industries. 

Apprenticeship Job Creation Tax Credit

The Apprenticeship Job Creation Tax Credit (AJCTC) is a unique incentive that allows corporations to claim a tax credit for hiring apprentices in certain skilled trades. This credit is designed to encourage corporations to invest in training and to build a skilled workforce, which is essential for the long-term growth and sustainability of the Canadian economy. 

Federal Film or Video Production Services Tax Credit

For corporations in the film and video production industry, the Canadian government offers the Film or Video Production Services Tax Credit (PSTC). This credit is designed to promote Canada as a location for film and video production, providing eligible corporations with a tax credit on qualified Canadian labor expenditures. 

Health Spending Account (HSA)

An Health Spending Account (HSA) is a plan that allows businesses to provide their employees with tax-free funds for eligible medical expenses. For corporations, contributions made to an HSA are fully tax-deductible as a business expense, and for employees, the benefits received are tax-free. This dual advantage makes HSAs a powerful tool in a corporation’s benefits arsenal. 

Other Credits/Incentives

The list above comprises only a few of the many credits/incentives offered exclusively to businesses that are incorporated.  

Leveraging Corporate Insurance for Tax Efficiency in Canada

Many of our clients have had a trusted insurance broker and accountant guide them through the nuances of using corporate insurance to enhance tax efficiency. In Canada, corporations can utilize insurance plans not only as a protective measure but also as a strategic tax-saving tool. 

Tax-Deductible Premiums

Premiums paid on certain corporate insurance policies are tax-deductible. For instance, a policy that insures against the loss of a key person can be a deductible expense, reducing the corporation’s taxable income. 

Estate Planning and Insurance

For my entrepreneurial clients, I recommend considering corporate-owned life insurance as part of their estate planning. The death benefits from these policies can be used to fund capital gains taxes due on the deemed disposition of shares at death, providing a tax-efficient transfer of wealth. 

The Corporate Advantage

Corporations have the unique ability to hold certain types of insurance policies that can accumulate an investment value tax-free. This can be a significant advantage when planning for the long-term financial health of both the business and its shareholders. 

Incorporating insurance into your corporate structure requires a careful analysis to ensure alignment with your overall tax strategy. I advise working closely with a specialized insurance advisor and accountant to tailor a plan that maximizes your tax savings while securing your corporation’s financial future. 

To learn more, check out our article, How Can I Save Taxes by Incorporating in Canada?

Potential Tax Disadvantages of Incorporation

Incorporating a business in Canada, while beneficial in many ways, may have some disadvantages.  

Investment Income

While incorporating your business in Canada opens the opportunity for massive tax savings via tax deferral, this only applies to active income. Active income is money that your company earns in the usual course of business, as opposed to passive income like income from interest or rents. Investment returns within a corporation are taxed comparably to personal income, negating any significant tax postponement for such passive earnings. For entrepreneurs and business owners, this insight is crucial when strategizing for tax efficiency. 

Tax Losses Trapped in Corporation

In my professional journey as a business advisor, I’ve learned that tax considerations should not drive incorporation for businesses not yet breaking even. While incorporating can shield you from liability, remember that corporate losses stay within the company and can’t be applied to your personal tax situation. In contrast, sole proprietors can leverage losses against other income streams or future profits. This distinction is pivotal when evaluating the timing and benefits of incorporating your venture. 

For example, Diana runs a small café as a sole proprietor and this year, unfortunately, the business has incurred a loss of $20,000 due to unexpected market conditions. As an unincorporated business owner, she can use this loss to offset her other taxable income, for example from her rental property and her part-time consulting job—thereby reducing her overall tax liability for the year. 

If, on the other hand, her bakery was incorporated, the $20,000 loss would be locked within the corporation. She could only use the loss to reduce future corporate profits from the bakery itself. This means that if the bakery turns a profit next year, she could use this year’s loss to lower the taxable income of the corporation at that time. However, she wouldn’t be able to use the corporate loss to reduce her personal income from other sources, which could be a significant disadvantage in the short term if I’m relying on multiple income streams. 

How an Ontario Incorporation Lawyer Can Help

When considering incorporation, a crucial first step is to speak to an incorporation lawyer.

At DiMinno Rizzi Lawyers, we offer free consultations to learn about your business and discuss whether incorporation is the best decision for you. We’ll work closely with you to help clear the fog and ensure that your company is sailing in the right direction!

 Disclaimer: All number figures are approximate only and may be subject to change. Like all material on this website, this is not financial, legal, or tax advice. Contact a professional for your specific situation.